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Securities Law and DAO Tokens

Sam Sklar


When analyzing any law, it’s important to look at the original text, the governing body that oversees it, and how it’s been interpreted over time. Despite 90 years of securities case law, legal opinions on cryptocurrencies are still developing. The SEC is still wrapping their heads around this rapidly evolving space. While it’s popular amongst the web3 community to hate on traditional finance and the government, we have to recognize that it is the mandate of the SEC to protect investors (which I’d hope we can all agree is important) and that crypto has not come without its share of fraudulent token sales.

The information expressed here is not a formal legal opinion. Do your own research - and if you think that your unique use case requires expert guidance, go get it. We are happy to recommend some firms that are well versed in this space.

This article is focused on the US, but we will continue to update it with relevant information on other regions as we do more research.

What is a Security?

Every securities discussion begins at the Howey test. While the landmark securities laws were enacted in 1933 and 1934 in response to massive losses during the Great Depression, they weren’t pressure tested until 1946. In the 1940s, the Howey Company sold tracts of citrus groves to investors with the promise that the company would tend the land and share in the profits with investors.

The Howey company, thinking (or hoping) that these arrangements did not constitute an investment contract, failed to register this offering with the SEC and make the necessary disclosures to investors. The courts disagreed - and in doing so established a 4 part test to determine whether future products are investment contracts (and therefore securities).

An investment contract involves:

  1. An investment of money (this has been expanded to include any investment of anything that has value)
  2. In a common enterprise
  3. With the expectation of profit
  4. To be derived (primarily) from the efforts of others

Following these rules, the Howey Company's investment product was a security.

The citrus groves required an investment of money into the common enterprise that is the Howey Company.  There was an expectation of profit from the sales of citrus, and those profits depended on work done by the Howey Company tending the fields and taking the fruit to market.

Why does it matter if my token / NFT is a security?

The SEC requires new security offerings to be registered with a prospectus that informs the public about the nature of the offering and the company behind it. The prospectus also includes audited company financial statements, information on key members, and the risks behind the investment. If the SEC approves the registration, and the company hosts a successful fundraise, they are required to file annual 10-Ks and quarterly 10-Qs. All this to say that it’s not impossible to formally register with the SEC, but producing audited financial statements and the ongoing reporting requirements can be onerous.

The SEC does allow for some exemptions to securities registration requirements. But to qualify for one of these exemptions, you need to limit your offering to accredited investors and there can be no general solicitation or advertising. You can read more about private placement exemptions here .

Why are layer one coins not a security?

Fiat currencies, while often traded for profit (the average foreign exchange daily trading volume is $6.6 Trillion!) are not considered securities because their primary purpose is to be used as a form of payment. They don’t have intrinsic value other than their ability to be traded for other goods.

The SEC classified Bitcoin as such and it is therefore not considered a security. Ether, the utility token behind the Ethereum block chain, is not as commonly used for payments (although the same could be said for Bitcoin). However, since the Ethereum block chain is sufficiently decentralized, and continued development doesn't depend on a core centralized group to work and promote the value of Ether, it too is not a security. [ CNBC ]

It’s this point, relating to part 4 of the Howey test, that is particularly relevant for our discussion of DAOs. We’ll touch more on this in the “How should we structure our token sales to avoid scrutiny?” section below.

Why is physical art not a security? What about digital art?

Art, while widely speculated on and sometimes worth millions, is not commonly regulated as a security. The thinking is that art is traded for the intrinsic value of its beauty even if investors also may seek to earn a profit. Moreover, thinking back to the Howey Test, while the creation of the artwork at one time depended on the effort of others, once completed any future appreciation will not depend on continued efforts from the original artist.

Applying this to NFT projects, digital art that can be appreciated for its intrinsic beauty is unlikely to be considered a security. But an NFT project, where the NFT represents ownership rights to a project, and the success of the project depends on the development efforts of a core team or company, may very well be a security.

Things get even more complicated when shares of artwork are fractionalized and shared. Masterworks, a platform set on democratizing the rare art market through fractional ownership of famous pieces, files its offerings with the SEC. Investors in Masterworks depend on the company to determine the investment strategy and primarily benefit by the return on their investment as they do not actually get to custody the pieces in the portfolio. [ Dilendorf ]

What can we learn from existing crypto case law?

The DAO , the original DAO, was an investment vehicle through which members of the Ethereum community pooled their assets to invest in crypto projects for the purpose of getting a return on their money. While decentralized in name, all proposals needed to be approved by the DAO “curators”. Due to the outsized influence over the investment decisions by the creators, the SEC decided the DAO tokens were securities. Ultimately, the project flopped not because of the SEC’s decision but rather because the DAO was hacked and lost half of its assets. Famously, the hack was reversed when the Ethereum community hard forked to create a new asset, leaving behind “Ethereum Classic”. [ Coindesk ]

The SEC determined XRP, the currency behind Ripple, to be a security because they argued that the value of XRP largely depends on the future efforts of the Ripple team. The Ripple CEO and the SEC are still working it out in court today.

The 2017 ICO boom saw the most truly fraudulent projects as well as the fiercest action by the SEC. Many firms faced civil penalties and some were forced to refund funds to investors. The outcome of your project may depend on your intent as much as the rule of law. Those who make a good faith effort to do right by their community, even if found to be out of line of current legislation, often at worst end up needing to return funds to investors. Those who make premeditated plans to orchestrate a rug pull are likely to face harsh penalties.

Some relevant cases:

  1. fined $24M for unregistered coin offering
  2. Unikrn fined $6M for unregistered coin offering
  3. Telegram fined $18M and forced to return $1.2B to investors

How should we structure our token sales to avoid scrutiny?

If ownership of your DAO is sufficiently distributed, and the future success of your DAO is dependent on the collective effort of your community, then your DAO token is unlikely to be a security based on current definitions.

Alternatively, if your DAO has strong central leadership that owns a meaningful stake, and the rest of the contributors are passive participants hoping to see a return on capital based on the efforts of the core team, then your DAO tokens are likely a security.

Equally important is the messaging used to promote your community. We commonly see members of the community promising that a token “will moon” in the near future. We see people advertising outsized future returns to encourage running up the price only to dump their position in the future. If people are buying your token solely because they are led to believe that they will be able to flip it for profit in the future, no matter your level of decentralization you may be putting investors at risk and piquing the interest of the SEC. The purpose of buying a DAO token should be to have ownership and governance power in a community that users actively want to participate in because they see benefit outside of potential token appreciation.

Final Note

As much as we can learn from the past few years, this is an evolving space and it is important to be up to date and flexible as the regulatory environment evolves. While operating with the best intent for your users can help your case, ignorance is not a defense against blatant disregard of the law.